What Is a Limit Down?

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DEFINITION
The term "limit down" refers to the maximum amount that a commodity future or stock price can decrease in a single trading day.

The term “limit down” refers to a U.S. Securities and Exchange (SEC) marketplace regulation called the limit up-limit down rule. Under this rule, there is a limit up and a limit down regarding the maximum amounts a commodity future or stock price can increase or decrease in any single trading day.

Keep reading to better understand what the term "limit down" means as well as how it affects individual investors and markets.

Definition and Example of Limit Down

The term limit down refers to the maximum amount that a commodity future or stock price can decrease in a single trading day. On the flip side, the term "limit up" is the maximum amount a commodity future can increase in that daily time limit.

Both terms come from the limit up-limit down rule, a marketplace rule created by the SEC to help protect futures contracts from unusual market volatility or unexpected events in U.S. equity markets. With these events, there are typically massive changes in commodity prices. The SEC aimed to stop this volatility by preventing trades that exceed the price bands established throughout that day’s trading hours for individual exchange-traded funds (ETFs) and stocks.

If there are no limits down or up, there is a chance that a futures contract’s price will surge or drop to an irrational value simply because of market panic.

Limits in either direction can lead to pricing discrepancies between the market price and the price reflected in the corresponding futures contract. When markets make major moves during a very short time period, this can cause the contract price to reach its limit down (or limit up) for a few days before making its way toward matching the market’s price again.

You’re also likely to hear the term limit down in reference to the Limit Up-Limit Down (LULD) Circuit Breaker, a type of single-stock circuit breaker. The LULD acts as a market volatility moderator by preventing those large, sudden price moves in a stock that the Limit Up-Limit Down Rule set out to prevent.

How Limit Down Works

Limit down, and the entire Limit Up-Limit Down rule, applies to any National Market Systems (NMS) stock, which includes the majority of stocks listed on an exchange. This can include nonconvertible and convertible preferred stock.

The price band of a stock is based on a certain percentage level both above and below the average price of the stock over the immediately preceding five-minute trading period.

Both limits down and limits up actively prevent trades in NMS securities from occurring outside of the previously mentioned price bands. Generally, in either direction, the limit is set as a percentage of the market price of the securities at hand.

Let’s break down how the process works. If a stock’s price moves to the price band but doesn’t move back to the original price band within 15 seconds, the stock will stop trading for five minutes.

Since enacted, the SEC has made various regulatory changes to ensure that trades do not occur outside the price bands and any pauses in trade are honored. Before this process was instituted in 2011 (following extreme market volatility that occurred in May 2010), there was no five-minute trading pause. The pause currently in place makes it easier to accommodate for fundamental price moves, according to the SEC.

Usually, the percentages for these price bands are 5%, 10%, 20%, or whichever is less between 15 cents and 75%. How the percentage is chosen depends on the price of the stock, the time of day the change occurs, and the tier that a stock is in.

The S&P 500, the Russell 1000, and exchange-traded products are considered Tier 1 NMS stocks. Meanwhile, NMS securities, excluding rights and warrants, are Tier 2 NMS stocks.

Key Takeaways

  • The term “limit down” refers to the maximum amount a commodity future or stock price can decrease in a single trading day.
  • Limit down comes from the Limit Up-Limit Down Rule, which was created by the SEC to fight high levels of market volatility.
  • By contrast, limits up do the opposite of limits down, placing a limit on how much the price of a commodity or stock can increase.

Article Sources

  1. Investors.gov. “Stock Market Circuit Breakers.” Accessed Dec. 3, 2021.

  2. U.S. Securities and Exchange Commission. “SEC Announces Filing of Limit Up-Limit Down Proposal To Address Extraordinary Market Volatility.” Accessed Dec. 3, 2021.